“You can make a break
You can win or lose
That's a chance you take
When the heat's on you” – Glenn Frey, The Heat Is On

There was a provocative letter sent to me a month ago
(an anti-VC rant) that I chose to respond to at length
in my mid-summer issue. That happens below. To start,
I thought I’d make a few comments on the state of things
as we gear up for the second half of 2004:

IPOs down, M&A up – The public markets are not being
kind to technology of late. Certainly the dramatic
change in earnings from 2002 to 2003 is not appearing in
the 2003 to 2004 numbers. The warnings of Veritas,
Intel and Nokia have shaken the industry into thinking
that IT spending has slowed. Perhaps expectations
merely got ahead of themselves. I think we are back to
the old days where technology buying cycles slow in Q2
and ramp in Q4. Look for better numbers at the end of
the year. The IPO market in Canada and the US perked up
for 6 months and is now lukewarm due to this effect.
But M&A continues at a solid pace. Companies that have
righted their ship since 2002 are looking for
acquisitions that can get them into new markets. They
are buying for growth. Cisco, Broadcom and IBM are
buying again and are not shy about paying for
non-revenue or low revenue companies (i.e. not accretive
to earnings) because they are expanding into new markets
and need the innovations of the start-ups.

There must be IT jobs out there – Entry level jobs must
be increasing locally as EA, Business Objects, MDA,
Nokia and Sierra Wireless are hiring. More evidence of
the lower cost of business here comes in the form of JP
Morgan opening a call center, although only a few IT
jobs will come from that. The biggest piece of
anecdotal evidence I have is that no one has sent me a
letter in the last 6 months complaining about the job
market and the number of resumes coming to Greenstone
has slowed perceptibly. The fact that some of our
companies are having management and employees getting
recruiting calls is another sure sign.

Governments and Technology – The minority government of
Paul Martin will likely do nothing much for the
technology industry that wasn’t already contemplated
when they had a majority government. I don’t think new
initiatives will get much support, especially if the
Liberals need to appease the NDP party to get things
done. This will be a government of major issues and
minor ones will simply not get support. As for our
provincial government, have we kept score on Mr.
Campbell’s commitments to the technology industry made
back in 2001? Where are we on the 3x more engineers and
4x more investment? While some progress has been made,
an upcoming election in 2005 is not going to ride on the
technology industry’s votes.

I
have worked for companies that have been partially
financed by a particular local VC, that prides itself in
its expertise and ability to step in and help manage the
company that they are investing in. This sounds very
appealing to the investors of the VC. These guys are in
control! In two cases I watched as the CEOs that they
had appointed to run these companies, rape and pillage
the company. They were 100% focused on their personal
gain, and frankly did not give a damn about anybody
else. These CEOs were paid handsome salaries and had
lots of perks. As this charade was going on, the VCs
were rarely visible, and took forever to fire these CEOs
that they had touted so highly and not before a lot of
damage was done to the company, its reputation and its
clients. The companies both failed and were eventually
sold merged or whatever.

Unfortunately VCs for the most part are using OPM (other
people's money). Yes they may have their own skin in
the game, but it is being offset to a certain degree by
the fact that they are drawing a pretty decent salary,
bonus etc. and also have the upside potential should
their investment prosper and actually increase in
value. This is not the case for the people that invest
along side of these VC principals.

I
do not want to paint all VCs with the same brush, but I
am very careful in who I approach when I am looking for
investment partners for my clients. One of my
observations is that a lot of people in the investment
industry, brokers, VC's, fund managers and other
participants often have not had any exposure or
first-hand experience to the operations side of a
business. Whenever I sit through a presentation by a
company seeking financing, it very clear to me that the
investment industry folks are very focused on the
financial side and less so on the operations side. Pro
forma financials are presented with all of their blue
sky which will impress the potential investor. A common
question is what is the home-run with this company which
translates into how am I going to make money quick. A
more important question is how realistic and achievable
are the pro-forma numbers. It seems to me if you have
never worked in the operations side of a company or
never worked outside of the investment industry you
would have difficulty in understanding the complexity
and challenges faced in running a successful company.
Therefore, how good at analyzing financials can you be.
You really can only take the word of the people giving
the presentation.

Another area of concern to me is the sales, marketing
and distribution. I often hear the argument that the
total market size is say $2 billion. We should be able
to get at least 2% of that market or $40 million if my
math is correct. This seems such a simplistic view of
the world and the challenges ahead. It is never quite
as simple as that. This is often the Achilles heel of
the company. Many companies have a proven product or
service, but the task of taking it to a viable,
profitable commercial level is completely another
story. Here again, I am sure that many of the
investment folks do not comprehend the difficulty, time
and work involved in successfully launching a product or
service. Do you go direct indirect, North America,
Europe, Asia and on and on.

I
have read recently that the returns generated by VCs for
their investors is pretty abysmal. Again I am not saying
this is the case for all VCs. But from an outsider's
view looking in, it looks like a very scary proposition
for me as an investor or a company that is considering
using a VC to know who to use and who to trust. I can
say one thing for sure, I know who I would not use.
From most of the companies that I have talked to in the
last couple of years, they feel that a VC is not a good
alternative source of capital as the VC wants the lion's
share of the spoils and provides questionable value.

Best regards

Paul Brown

Thank you for taking the time to prepare a long and
emotional letter. You are putting in writing a
sensitive topic and I will respond without any bias
whatsoever {grin}. I’ll try to address your main
points, which I see to be:

-
VCs you have worked with lack operational expertise
leading to bad decisions at the Board level

-
Co-investing with VCs is problematic because, even if
they have skin in the game, it is not enough to offset
the fact that they can afford a few losses in their
portfolio and thus, pay less attention than they should
when things go bad, but get more upside than they
deserve when things go well.

-
VCs that you have worked with don’t appear to do enough
diligence and take the word of the entrepreneur too
literally on upside of the opportunity without realizing
the underlying complexity in growing a business

If I’ve got that all correct, then here are my comments
back to you:

The venture business has no “school” to learn at other
than some cursory basics in business schools. Good VCs
are made by years of experience. A wise 23 yr veteran
of the Silicon Valley told me that the most expensive
MBA in the world is learning to be a VC because it costs
millions of dollars and at least 10 years to see and do
it all. I can count on one hand the number of VCs in
this town with that length of experience (one of
Greenstone’s partners has 10 years, the others have 7
each if you are keeping score at home).

VC is broken down into three functional areas: Picking
good deals, managing/helping deals through the lifecycle
(good or bad) and raising money from investors. Since
the third task is irrelevant to your comments, we will
ignore it. Let’s start with the first task. Picking
good deals is art, not science. If you were operational
prior to being a VC you have no advantage in this part
of the game. In fact, most new VCs from industry are
far too optimistic and unrealistic in expectations of
opportunities that they see. I fell into that trap in
1997 when I left the software business. I thought each
deal was the best one I’d seen. It seems to me that
many deals get done, and will continue to get done, that
are, in the beginning, very poorly thought out and
woefully short of management talent. The other end of
the stick is old, grizzled VCs that don’t like any deals
and it is like pulling teeth to get them to take some
risk.

Why do crappy deals? Some VCs have quotas to invest.
Others have time pressures put on them to get money
out. Some are very inept at performing diligence and
asking the right questions. And inexperienced VCs can
do bad terms in deals that either hurt the company or
hurt themselves. But crappy is always in the eye of the
beholder. In the egocentric world of VCs and
entrepreneurs, every deal that isn’t theirs is crappy.
You have made the same subjective analysis in your
comments.

In the managing/helping company’s part of the VC
business, every VC mentions “value add”. The most value
add is experienced decision making at the Board level
and great networks of high level contacts that help the
company. In a perfect world, the entrepreneur would
hold sway and pick the investors that they want. Very,
very few entrepreneurs have the track record to be able
to do that, either here or in the heart of venture
investing, the Silicon Valley. But a good question to
ask yourself as you are getting money for your venture
is this: Would the investor about to sit on my Board as
part of their ownership of a large portion of my company
be someone I would think of for my Board even if they
would not invest? Would they bring the operational
experience that you talked about? The answer is likely
no. But there are VCs that do meet that high standard
and there are those that bring directors to their
companies that meet this standard. If you want
leadership from a VC and good decisions that benefit the
company, you should press for that kind of investor.

Your observation about “VCs not paying attention” is
accurate in some cases. The unfortunate truth is that
VCs play a portfolio theory, meaning multiple bets
placed in different stages and sectors. If things go
awry (and my experience is that VCs are not to blame for
most stumbles in businesses), that is usually when too
much attention is given by VCs. If they aren’t paying
attention, it’s a good thing if it means the
entrepreneur is free to build a business. If they add
no value at all, even when prodded for action, then
there is a problem.

When things go well, everyone is happy until they get
greedy. A huge win gives you remorse at how much of the
company went to others. It is completely natural to be
an entrepreneur and sweat and toil and make it all
happen and look at others making money as
“freeloaders”. But that thinking is dangerously
narrow-minded. The fact that VC exists as an industry
is because you can’t make a business as fast as you
would like without early injections of capital. When
you are mortgage free, do you think of your bank as
pirates for all the interest they took? Or do you thank
God that all of the years of living in that house were
made possible by the bank giving you that money in the
first place?

Finally, co-investing with VCs (that is going in on the
same round of investment as them) should not be an
issue, if you, like them, make bets elsewhere to
diversify your risk. If you have all of your capital
(or capital you raised from others) bet on one or two
companies, you are taking a huge risk. That happened to
a poor group of investors on one of my deals that
failed. While it hurt to lose millions of my investor’s
and my money, I can make it up on the other
investments. These guys had bet it all on black and had
nothing, thus ruining their and their investor’s
experience in technology

There are early stage, non-VC investors in VC backed
companies like Angiotech, Pivotal, Creo and Sierra
Wireless that are certainly not complaining about VCs.
There are plenty of investors that lost money that look
to cast blame, rather than share it. A particular group
of angels locally fit into that category… but alas, the
emperor is missing some clothing in their case. And
there are certainly instances of inept management and
Boards that led to losses. But the industry is what it
is. The investors keep raising money and turning to
entrepreneurs to help them make returns. We are not
unique in Vancouver and much of the bad sentiment is
cyclical due to the huge downturn we just went through.
At the end of the day, everyone needs to improve and
learn from mistakes and admit responsibility. The
industry improves if we all get smarter.

So, Paul, you can view VC as a necessary evil or you can
view it as a positive strategic partnership. Or you can
fund the next one on your own. As for the VCs, they
either pick up their socks or lose the really good deals
to firms that are deemed to have the value worthy of
gaining the spoils. That’s how the marketplace should
function.

Something Ventured is a bi-weekly column designed
to supplement the T-Net British Columbia web site with
some timely, relevant and possibly irreverent insight
into the industry. I hope to share some of the
perspective and trends that I see in my role as a VC.
The column is always followed by feedback (if its
positive or constructive. I'll keep the flames to
myself, thanks).